21/05/2010: The Financial crisis for everyone

The world changed on May 9 with the Eurozone's trillion dollar bailout plan. With governments squeezed between the politically unacceptable remedy of inflation and the dubious medicine of covering debts by printing money, the path ahead now seems clear.

The sovereign debt crisis in Europe is not an isolated event. It is merely the second act of a tale that started in mid-2007 and reached its dramatic peak in September 2008 with the fall of Lehman Brothers. The jargon employed by many experts to explain what happened when credit stopped flowing can be daunting for the layman. This is unfortunate since the crisis followed, and continues to follow, a rather simple pattern that is common to the bursting of most financial market bubbles. Like a classical tragedy, the credit crisis that still roils markets today has a prologue and unfolds in three acts.

Prologue: Living large till the bills come in
Financial bubbles are as old as history itself. Whole libraries are filled with lively, funny and sometimes shocking tales of past financial follies. With the benefit of hindsight, we are often puzzled by the recurring madness of crowds.

How could it come to pass that one bulb of an exotic flower could sell for ten times the annual income of a skilled craftsman, that the park surrounding the emperor’s palace in Tokyo could be assigned a value equal to that of California's entire property market, that a back-of-the-napkin business plan from a couple of teenager whiz-kids could be worth more than a hundred-year-old blue chip company with solid earnings and tens of thousands employees? We are seduced again and again by the four most dangerous words in the financial industry: "This time is different," which is also the title of a compelling history of financial bubbles by US economists Carmen Reinhart and Kenneth Rogoff, published last year.

Indeed, even as we grapple with the consequences of the latest excesses, the next bubble is probably already in the making, as we shall see.

That we are so ready to believe the false promises of financial bubbles defies mainstream economic theory, which assumes human beings are rational and markets are efficient. But it now seems clear that economists need to look to other disciplines – psychology, sociology and history – to better explain our dangerous gullibility.

Buying into a bubble is certainly not a sign of stupidity or lack of economic education. Former Fed Chairman Alan Greenspan didn't recognize the Tech bubble, bloated by its fantastical valuation metrics, because he liked the narrative of a new economy spurred by technology-driven productivity gains. Current Fed Chairman Ben Bernanke argued as late as 2005 that pumped-up US house prices "largely reflect strong economic fundamentals." These examples show that even sharp economic minds succumb to the mirage of bubbles.

But just as a fire needs oxygen to burn, financial bubbles need money and the promise of more money – that is, credit – to inflate. And fear that the ample liquidity and credit might dry up can cause a bubble burst. After this prologue follows a tragedy in three acts.

Act 1: Suddenly the air left the bubble…
Once a bubble bursts, balance sheets suddenly take on a grotesque appearance as asset prices plummet while liabilities remain constant. Both sellers and potential buyers fear the fall in asset prices, and even if assets could be sold, their reduced values would not cover the seller's liabilities. This was experienced in the first act of the credit crisis. Many households and many financial intermediaries became insolvent. While the insolvency of private households may not pose a massive threat to the economy, failing financial intermediaries can have very disruptive consequences, as we have seen.

Governments' rescue plans took the form of bailouts and even of nationalizations of some banks and the purchase of banks' toxic assets by the state. In general, governments took the most toxic and fragile elements of the financial sector’s balance sheets into their own accounts.

These were drastic, even shocking actions but they succeeded in stopping a dizzying flow of events that could have spun out of control. Reinhart and Rogoff calculate that over the last 200 years a banking crisis of the size we have just experienced consumes roughly 40% of GDP. This matches well with the International Monetary Fund's estimate that the public sector's debt-to-GDP ratio in developed economies will have surged from 80% in 2007 to 120% by 2012.

While the economic recovery has been uneven, our good fortune is evident if we consider an alternate history – one in which, after the Lehman bankruptcy, other financial intermediaries were not rescued: first, our credit cards would cease to function, and then the automatic teller machines would freeze. Lines would form in front of closed banks and transactions of all sorts would break down. In short, economic activity would have screeched to a halt.

In any case, even with the rescue of so many financial intermediaries, many developed countries have suffered the worst recession since World War II.

Act 2: The public sector quakes
The financial crisis could have stopped at the end of Act 1. The US saving and loan crisis and Swedish banking crisis at the beginning of the 1990s ended right there. Despite the surge in public debt and its possible long-term burden growth and boost to inflation, many financial crises have petered out before the second act. However, during this financial crisis, three major problems arose that ultimately shook the halls of government.

First, while recent financial crises were confined to a few countries, the latest convulsion affected both the US and Europe, which together still account for over 50% of global GDP. Over the last forty years, only the Asian crisis of 1997-98 can be compared in importance although not in sheer size to the events of 2008. The new debt raised by the US and the European governments is immense. According to The Economist World Debt Clock in 2009 and in 2010 roughly 5 trillion US dollars in new public debt will have been raised worldwide. For 2011 and 2012, debt increases in similar order of magnitude can be expected.

Second, this new debt comes at a moment when the government debt of developed economies is already extremely high by peacetime standards. On top of that, most governments in the developed world are facing the challenge of aging populations, a demographic shift that will further stress public finances. In fact, adding the so-called "unfunded liabilities" implicit in various government programs to current public debt, these "off-balance-sheet" liabilities create a financially unbearable situation.

Finally, this surge in new debt has hit countries that have no authority to monetize it. Debt is said to be "monetized" (turned into money) when a government issues debt (bonds) to finance its spending and the central bank then buys that debt, printing more money to do so. That is one reason why we have a European and not a US or a UK sovereign debt crisis today. Greece is insolvent and at risk of defaulting because its debt is calculated in euros and it cannot use the printing presses to monetize it. This is a choice that countries like Japan, the UK or the US still have. Which leads us to the final act of this financial drama.

Act 3: The big flush
Reinhart and Rogoff assert that there is no empirical relationship between public debt and inflation. While this might be puzzling at first glance, it will not surprise monetarists, who see inflation purely as a monetary phenomenon. According to this view, inflation would follow high levels of public debt only if that debt is monetized, that is, if the printing presses were used to repay the debt. Given their massive debt problems, several countries, including the US, might be tempted to print their way out of trouble since it hurts too much to swallow the bitter medicine of depression.

Indeed, this is how we think the current financial crisis will end. Why? For one thing, economic policy is made in a political and social context. This reality adds a layer of considerations to the remedies that governments select. It requires a brief outline of how these forces interplay:

The credit problematic can be seen as a conflict between lenders and borrowers that can be solved by favoring one side or the other. Creditors are the savers, the pensioners and older people generally. Germany is the creditor to the Eurozone while China plays that role for the world. Debtors include entrepreneurs and younger people. The US, the UK and the Mediterranean countries of the Eurozone are clearly in the debtor's camp.

Since governments are also usually borrowers, they inherently favor debtors over the creditors. This is somewhat counterbalanced by the fact that older people are more inclined to vote than younger people; hence the usual posturing of governments against inflation.
Favoring creditors would lead to defaults and increase the likelihood of a deflationary, Depression-like situation. This, it must be said plainly, is the outlook for the Eurozone's Mediterranean countries, which have committed to drastic austerity measures.

On the other hand, economic wisdom says that favoring debtors will lead to inflation. Given that not only the government but also many households are heavily indebted in the US and the UK, it is very likely that inflation would be the most acceptable outcome, at least in those two countries. Until two weeks ago, this was not at all clear for the Eurozone. After all, the European Central Bank was formed with one clear mandate: to fight inflation.

However, we think the balance of power within the Eurozone and the ECB shifted from Germany towards the Mediterranean countries on 9 May. By agreeing to buy the sovereign debt of distressed Eurozone countries, the ECB has adopted the so-called "quantitative easing" measures that were undertaken by the Fed and the Bank of England. That is, in layman's terms, the ECB is also monetizing debt and massively increasing liquidity.

And the show goes on
Act 3 once again shows why economics is known as the "dismal science." A hangover usually follows a wild party, and after the roaring 2000s we see only two possible remedies: deflation/depression (this is how Japan's playbook got stuck since 1992) or inflation. Cost-cutting is universal in our globalized world. Last year's Great Recession left many countries with high unemployment and a lot of unused capacity. In such a pinched environment, creating inflation is a challenging task, one that we do net expect to occur anytime soon.

More likely, in our view, the global liquidity flood that was so massively boosted on 9 May will succeed in raising asset prices again, and along with it, overall market volatility. Ultimately, this surge in money may well pave the way for the next bubbles, just as the excess liquidity after the Tech bubble set the stage for the housing and credit bubbles. The show, it seems, must go on and on….